Papale on Theta

It is finally over.  Barack Obama was re-elected President of the United States on Tuesday.  All the campaigning, debating, spending more money than the GDP of a small country is finished.  Markets sold off on Wednesday spurred by renewed problems in Europe, concerns about the fiscal cliff, a continued fall in Apple.  On election night “The Donald” put out a tweet that was picked by the newswires.  It seems Donald Trump took exception to the election results and blasted out a tweet challenging it all.  The Donald and his hair could be marching on Washington sometime in the near future.  Maybe he starts a new show ‘ The Apprentice – March on Washington”.

The last couple week,s we have been going over the greeks.  So far we have covered delta and gamma.  This week let’s take a look at theta.

Theta  measures the daily rate of time decay the options incur between now and expiration.  An option is a wasting asset.  What that means is it has a finite life span and at a predetermined date it expires.  At that point it is worth only its intrinsic value; r0, if finishing out of the money or the difference between its strike price and the underlying if finishing in the money.  However, up until expiration there is an extrinsic or time value embedded in the option price.  This is the risk premium in the option and moves up and down as measured by implied volatility.   This extrinsic value is the portion of the option value that decays over time until it is completely gone at expiration.  Options that are far out of the money or far in the money have very little or no extrinsic value even before expiration.  This is because the extrinsic or time value is proportional to the likelihood the market is placing on that particular option finishing on the other side of at the money from where it is.

For example,  with XYZ trading at 100, the 150 calls might be worth $.05, which is all extrinsic value.  This is suggesting the likelihood of those options finishing in the money is very low, as the delta would indicate.  On the other hand the 50 calls might also have extrinsic value of $.05 even though the delta is .99.  This low extrinsic value again reflects the markets belief these options will finish in the money, hence risk premium (extrinsic value) is very low.  As most of us know, the at the money strike has the greatest theta as it is the point of greatest uncertainty and hence greatest extrinsic value.

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